Target-Date Funds 2.0: Sturdier Shock Absorbers

After target-date funds took massive losses in 2008-most notably, those with a near-term retirement date that were supposed to protect investors' money-many on Wall Street expected target-date investors to move their savings elsewhere.

But according to Morningstar, most people have ignored the criticism and made target-date funds the focus of their retirement savings.

Target-date funds are retirement plans that combine stocks, bonds and other investments and become more conservative as an investor approaches retirement age. They take the guesswork out for investors by allowing investors to choose the year they intend to retire and have the asset allocations automatically chosen for them.

Morningstar's, which includes research on 20 of the largest target-date series, revealed that more than $45 million in new cash flowed into these funds last year. The survey examined investor returns, which reflect monthly flows in and out of funds, and the returns earned. With target-date funds, investor returns over the past three years exceeded the funds' total returns in every target-date category except for one, and far exceeded returns on a traditional mutual fund, according to the survey.

"Target-date funds have been the subject of unprecedented regulatory, governmental, and media criticism in the wake of 2008's market slide, but that has not deterred millions of investors from making these funds the centerpiece of their retirement savings," said Laura Pavlenko Lutton, editorial director for Morningstar's mutual fund research group. "Target-date funds have become the retirement vehicle of a generation, and for some good reasons. The funds have structural advantages over traditional mutual funds, including generally lower costs and dynamic asset allocation that automatically grows more conservative as investors' age."

The good news is that Morningstar found that fund companies have responded to the recent criticism of target-date funds. In general, fund families in the survey have tried to lower fees. And several fund series have attempted to reduce risk by lowering the funds' equity allocations, which is what led to such large losses in 2008.

'Whipsawed'

But Lutton isn't sure that changing the funds' equity exposure is the answer. "Lower fees directly benefit investors, but changes to the funds' equity exposure could leave the industry open to charges that it's fighting the last market battle, and not positioning the funds correctly for the future," she said. "Indeed, some funds that were aggressively positioned in 2008 were whipsawed when they turned conservative prior to the market rebound in 2009."

At the recent American Bankers Association conference in Phoenix, there was a lot of talk about the advantage of "open architecture," which are managers that are independent of the fund's advisor. Nonetheless, Morningstar's survey found that even though in the aftermath of the financial crisis some members of Congress and the media criticized fund series that used only proprietary managers, there is no advantage or disadvantage to open architecture.

One area of concern for Morningstar, however, is disclosure and manager investment in the funds. Morningstar found that many fund families don't meet the minimum levels of disclosure and manager investment recommended by the Investment CompanyInstitute. Nor do these funds provide the details necessary to understand the target-date funds' potential risks and rewards. In addition, fund managers have a relatively low level of personal investment in their funds, meaning their own financial interests were not aligned with shareholders.

"Investors should remain concerned about the flimsy public descriptions of how target-date funds are run and the low absolute levels of manager investments in the funds," Lutton said. "It's critical for individuals to easily understand their target-date fund's goals, strategy, and risks, and it's important for fund managers to have some skin in the game."

Patrick Cunningham, a managing director at Manning & Napier Advisors, an asset-manager specializing in target-date funds with over $25 billion in assets under management, is confident target-date funds have started to address many of these critiques. The question is: what will the revamped funds look like?

Cunningham said that in the next year, a new generation of funds will emerge. "The first generation of target-date funds were flawed, and it's time for the funds to grow up," he said.

He expects the second generation of target-date funds to have more flexibility within funds for asset allocation, an increased focus on risk-based funds that enable employers to put risk controls in place on behalf of their employees, less funds-of-funds, which had less risk protection during the recent downturn, and a larger mix of asset classes in funds, and better communication from fund companies.

"In the last of couple years, the risks of 401(k) investing were clearly revealed," Collinson says. "I wouldn't call 401(k) plans a failure, but I think we've learned there's still opportunity for improvement, including the 77% participation rate," said Catherine Collinson, president of the Transamerica Center for Retirement Research.